by Ali Mir
If you don’t understand the financial crisis on Wall Street, don’t fret. No one does, least of all the experts. What we do know is that it is an unholy mess, which is about to get worse. Here’s a quick FAQ for those who don’t wish to wade through dense treatises on collateralized mortgage obligations, asset backed commercial papers, and blah-blah-blah. It’s hardly comprehensive, but it can serve as a starting point for engaging with the issues surrounding "the greatest financial debacle since the Great Depression."
Do the roots of this crisis lie in the housing bubble?
The roots are all over the place (for instance, in the absence of regulation and oversight, in the growing inequality in America, in rising debts among the middle and working classes, in the offshoring of manufacturing, in the decline of the union movement), but for the sake of simplicity, let’s say yes. After 2001, the Fed kept its interest rates low in order to increase liquidity and encourage spending. Financial institutions offered easy credit to those who wanted to borrow money to buy a house. Many who did not qualify for loans at regular market rates – the subprime borrowers – were persuaded to take out mortgages despite the fact that their income level, ability to make a down payment, and credit history made them high-risk debtors.
Why did so many borrowers take out mortgages?
As the number of buyers increased, the values of homes started going up. And as the values of homes started going up, the number of buyers increased. Everyone wanted to jump on the gravy train. In 2005 and 2006, 40% of homes sold in the U.S. were purchased as either investments or vacation homes. Financial institutions offered subprime borrowers “teaser rates” which were scheduled to go up after a period of time (these were the so-called ARMs – adjustable rate mortgages). Existing homeowners assumed that the value of their principal asset – their home – had increased (when they noticed, for example, what their neighbors’ home was selling for) and refinanced their mortgages, spending the borrowed money.
Why did the financial institutions lend so much money to these “subprime” borrowers? Weren’t they worried about defaults?
Not really. For one, many of the loans were made by mortgage companies that were not even banks. They did not lend money of their own; they merely collect commissions. Besides, the system was geared towards increasing revenues and profits in the short run. Bonuses were linked to current performance. But more importantly, many of these institutions were not taking much of a chance since the rights to these mortgage payments along with the accompanying credit risks were sold to third-parties.
So the risk passed on to the third parties then?
In some cases, yes. But for the most part, these third parties cut up these securities, mixed them up, repackaged them, and sold them down the line in the form of Mortgage Backed Securities (MBS), Collateralized Debt Obligations (CDO), Collateralized Mortgage Obligations (CMO) and a whole host of other esoteric instruments. There was little, if any, regulatory oversight. At each step, the parties in this chain collected profits, and believed they were handing off the risk.
What was the role of AIG?
AIG offered insurance to those who bought MBSs in exchange for a fee. Credit rating agencies such as Moody’s and Standard & Poor’s gave a high grade to these securities. This meant that AIG did not have to post much collateral, since it was assumed that these securities were not risky at all.
I am not sure I understand how the insurance system works.
Assume that you have bought $1 million worth of securities. You are worried that the assets behind these securities are not a sure bet. So you hedge by buying $1 million insurance from AIG. If there is a default on the payment, AIG pays you your $1 million. These are the so-called “credit-default swaps”. Pay attention to that term. We will hear a lot about it in the near future. There is currently a $62 trillion (yes, that’s a trillion) market for these swaps which is absolutely unregulated.
How much is a trillion anyway? Apart from being a large sum of money?
As figures keep getting tossed around, one begins to suffer from number fatigue. How does one make sense of these large values? Here’s one way to imagine a trillion dollars. Let’s say you have a magic machine that spits out a $100 bill every second, all day and all night long. In the first minute, you’d have $6,000. In the first hour, $360,000. In the first 24-hour day, you will possess more than $8.6 million. A year later, you’ll have a little more than $3.15 billion. In other words, it will take you and your machine more than 317 years to produce a trillion dollars.
So, back to our story. Wasn’t everyone making money?
Until a certain point in time. But as usually happens with a bubble, the quid came calling for the quo. Subprime borrowers defaulted on their loans when the higher ARMs rates kicked in. Foreclosures increased, putting a pressure on the now heavily inflated home prices. Excess inventory created by builders and speculators during the boom started to mount. As prices began to deflate, owners found it increasingly difficult to refinance their homes. The MBSs were not so attractive any more.
So institutions that owned MBSs were in trouble?
Exactly. Bear Stearns was the first to crash. The Feds had to step in and facilitate its “sale” to JP Morgan at the cost of $29 billion to the taxpayers.
And why did AIG stumble?
Credit rating agencies woke up to the fact that they had assigned AAA ratings to relatively worthless securities, so they downgraded the credit of AIG, requiring it to post additional collateral. Since AIG didn’t have the billions it would have taken to do this, it had to be rescued if it was to be prevented from declaring bankruptcy.
Why would that have been such a terrible thing?
If AIG went under, all those who had hedged their bets would have suddenly found themselves in a heap of trouble. They would have most likely gone belly-up too.
So AIG was too important to allow it to fail?
That is the narrative being bandied about. But the bailout wasn’t about AIG. It was done in order to save its “counterparties”, the ones who had bought insurance.
Who were these counterparties?
We are not sure. But around three-quarters were probably European banks. Had AIG gone down, Goldman Sachs would have taken a huge hit too.
Why wasn’t Lehman Brothers bailed out?
We don’t know. Perhaps it was the luck of the draw. It came second in line (after Bear Sterns) and maybe the government wanted to play it tough. Or perhaps its counterparties were not important enough to rescue. [Note added later: Here's one attempt at explaining why Lehman wasn't thrown a lifeline: http://freakonomics.blogs.nytimes.com/2008/09/18/diamond-and-kashyap-on-the-recent-financial-upheavals/]
What was the story with Freddie and Fannie?
Mac ‘n Mae together accounted for half of the $12 trillion mortgage market in the U.S. Several foreign central banks had huge holdings in these market giants, Chinese banks being prominent players, and were under the assumption – rightly, it appears – that these government sponsored enterprises would not be allowed to fail. China runs huge trade surpluses with the U.S. It needs to invest those greenbacks somewhere, and tends to place them in U.S. securities. This defacto borrowing is what funds the budget and trade deficits in the U.S. If Freddie and Fannie had not been bailed out, the foreign banks would have suffered huge losses, which would have had long-term consequences for the international financial system, and the ability of the U.S. to borrow money.
Now what?
The U.S. government is planning to rescue the financial institutions by buying up their “illiquid assets” (stuff that no one else wants). Some call it a “cash for trash” deal.
What if it doesn’t do this?
Financial institutions devastated by this crisis have very little capital to lend. The claim is that without the credit that they provide, the economy will suffer. How much is unclear, but the impact is likely to be quite severe.
What does the administration want?
The Treasury secretary is asking for unfettered access to an additional $700 billion in order to buy any asset from any institution at any price he thinks is right. Further, the Secretary says that his decisions will be “non-reviewable and committed to agency discretion, and may not be reviewed by any court of law or any administrative agency.” The government plans to buy up the MBSs at a price it determines (critics worry that lobbyists of the financial institutions will play a role in this), thus freeing the institutions to infuse credit into the markets.
Who will foot the bill?
Ordinary citizens – the taxpayers – who will see a skyrocketing deficit, and most likely, shrinking investments in public goods, dwindling retirement accounts, and greater inflation.
Why $700 billion?
No one is quite sure. It seems to be an educated guess. Of sorts.
Is there any alternative?
If there is one, it is not clear what it is. Some suggest that the government should demand an ownership stake in the companies it bails out (like the government of Sweden did when it faced a similar crisis in 1992). That way, if the firms recover, the money can be returned to the treasury.
So what were the regulatory lapses that allowed this crisis to take shape?
There were several. Institutions such as Fannie Mae and Freddie Mac were allowed to cut, mix, and repackage mortgages as abstract securities, and to resell them, thus creating a largely unregulated market for fancy and risky derivatives. Lenders of subprime loans were pretty much unregulated too, as were hedge funds and private equity firms, who were left alone to do as they pleased. But there were two major deregulatory forces that had more to do with this crisis than any other. One was the fact that investment banks were allowed to leverage their capital heavily. So for instance, for every $1 it held in capital, Morgan Stanley had $30 in debt. This allowed the financial institutions to bet heavily with borrowed money. Which was great as long as the going was good, but it magnified the losses massively when the downturn came along. The second problem was that the securites that were created out of the mortgages became desirable only because credit rating agencies like Moody's and Standard & Poor's gave them AAA ratings. The rating agencies charge financial institutions a hefty fee for issuing ratings, leaving them open to the charge of a conflict of interest.
Was the crisis primarily caused by irresponsible borrowers who took on loans that they did not have the ability to repay?
It’s true that defaults on mortgage payments, especially in the subprime segment triggered this crisis-in-waiting. It is also true that borrowers – both prime and subprime – failed to read the fine print, took out larger loans than they could afford to repay, and got carried away by the thought of buying property that was supposed to keep increasing in value. But the subprime loans were pushed by an unscrupulous industry, which preyed on a population that did not have the wherewithal to figure out the swindle before it was too late. A lot of educated, middle-class Americans lost out too, but the subprime crisis represents the greatest loss of wealth for poor people, especially for people of color, in modern history. More on this later.
Is Wall Street entirely responsible for this mess?
Of course not. Wall Street stands in for a system – as its alpha male – that is inherently inequitable, but also unstable and crisis-prone. We have seen this story repeated over and over again, in which profits are privatized, while losses are socialized. The tab is eventually picked by the taxpayers. This is how wealth gets redistributed from the poor to the rich. No wonder that the top .01% (14,000) families in the U.S. now own 22.2% of the nation’s wealth, while the bottom 90% (around 133 million) families, a mere 4%. We haven't seen such numbers in nearly a century.